Nicolas Véron: Testimony on the European debt and financial crisis

23 September 2011

The European crisis is entering a critical phase because policy initiatives undertaken so far have not prevented systemic contagion. Véron concentrates his remarks on the role of Europe's banking system in the crisis, the steps needed at the European level for the crisis to be resolved, and the short-term outlook.

This Policy Contribution reproduces the written statement prepared by the author for the hearing on The European debt and financial crisis: origins, options andimplications for the US and global economy at the Subcommittee on Security and International Trade and Finance of the US Senate Committee on Banking, Housing and Urban Affairs, on 22 September 2011.

The key points of Véron’s statement are as follows:

• First, Europe’s banking system has been in a continuous stage of systemic fragility since 2007-08, in contrast with the United States where banking crisis resolution was swifter and was essentially completed in 2009. The inability of European policymakers to resolve their banking crisis so far can be explained by deeply-embedded features of their respective countries’ financial systems and political economy structures.
• Second, the current phase, which is often described as a sovereign debt crisis, is really a sequence of interactions between sovereign problems and banking problems. Had western Europe’s banks been in a better shape a year-and-a-half ago, the policy approach to the Greek debt crisis would have been entirely different, possibly allowing for a much earlier sovereign debt restructuring. So the situation is best described as twin sovereign and banking crises that mutually feed each other. The result of this interaction is a gradual contagion to more countries and more asset classes.
• Third, the crisis has exposed a major deficit of executive decision-making capability in the EU and euro area institutional framework, which helps to explain the insufficient policy response. It can thus be said that the banking and sovereign crises are compounded by a crisis of the EU institutions themselves. Specialised European bodies, primarily the European Central Bank (ECB), have partly  bridged this gap with policy initiatives that go beyond a narrow reading of their mandate, but they could do so only to a limited extent that has not been sufficient to stop the contagion.
• Fourth, a successful crisis resolution will need to include at least four components at the European level, in addition to steps to be taken by individual countries: (a) fiscal federalism, i.e. mechanisms that ensure that fiscal policies in the euro area are partly centralised with shared backing across countries so as to meet the requirements of monetary union; (b) banking federalism, i.e. a framework for banking policy at the European level that credibly supports the vision of a single European market for financial services; (c) an overhaul of EU / euro-area institutions that would enable fiscal and banking federalism to be sustainable, by allowing centralised executive decision-making to the extent necessary and by guaranteeing democratic accountability; and (d) short-term arrangements that chart a path towards the completion of the previous three points, which is bound to take some time. These should involve expanded instruments to intervene in the banking sector and to provide interim funding to struggling euro-area governments, taking into account the possibility of insolvent Member States having to undergo debt restructuring.
• Fifth, these requirements for crisis resolution cannot be met unless political conditions change sharply in their favour. This leaves the US exposed to a risk of financial contagion, which it can partly mitigate with adequate contingency planning and proportionate precautionary measures. The US can and should also continue to play a constructive role by providing advice to its European partners, and thus helping them rise to the momentous challenges they face. However, only the Europeans themselves can solve their current predicament.

Full testimony

© Nicolas Véron